Thursday, March 26, 2009

Via an email suggestion (there's much, much more in the
full version):

Goodbye, homo economicus, by Anatole Kaletsky: Was Adam Smith an
economist? Was Keynes, Ricardo or Schumpeter? By the standards of today’s
academic economists, the answer is no. Smith, Ricardo and Keynes produced no
mathematical models. Their work lacked the “analytical rigour” and precise
deductive logic demanded by modern economics. And none of them ever produced an
econometric forecast (although Keynes and Schumpeter were able mathematicians).
If any of these giants of economics applied for a university job today, they
would be rejected. As for their written work, it would not have a chance of
acceptance in the Economic Journal or American Economic Review. The editors, if
they felt charitable, might advise Smith and Keynes to try a journal of history
or sociology.

If you think I exaggerate, ask yourself what role academic economists have
played in the present crisis. Granted, a few mainstream economists with
practical backgrounds—like Paul Krugman and Larry Summers in the US—have been
helpful explaining the crisis to the public and shaping some of the response.
But in general how many academic economists have had something useful to say
about the greatest upheaval in 70 years? The truth is even worse than this
rhetorical question suggests: not only have economists, as a profession, failed
to guide the world out of the crisis, they were also primarily responsible for
leading us into it. ...

Academic economists have thus far escaped much blame for the crisis. Public
anger has focused on more obvious culprits: greedy bankers, venal politicians,
sleepy regulators or reckless mortgage borrowers. But why did these scapegoats
behave in the ways they did? Even the greediest bankers hate losing money so why
did they take risks which with hindsight were obviously suicidal? The answer was
beautifully expressed by Keynes 70 years ago: “Practical men, who believe
themselves to be quite exempt from any intellectual influence, are usually the
slaves of some defunct economist. Madmen in authority, who hear voices in the
air, are distilling their frenzy from some academic scribbler of a few years
back.”

What the “madmen in authority” heard this time was the distant echo of a
debate among academic economists begun in the 1970s about “rational” investors
and “efficient” markets. This debate began against the backdrop of the oil shock
and stagflation and was, in its time, a step forward in our understanding of the
control of inflation. But, ultimately, it was a debate won by the side that
happened to be wrong. And on those two reassuring adjectives, rational and
efficient, the victorious academic economists erected an enormous scaffolding of
theoretical models, regulatory prescriptions and computer simulations which
allowed the practical bankers and politicians to build the towers of bad debt
and bad policy. ...

Which brings us to the causes of the present crisis. The reckless property
lending that triggered this crisis only occurred because rational investors
assumed that the probability of a fall in house prices was near zero. Efficient
markets then turned these assumptions into price-signals, which told the bankers
that lending 100 per cent mortgages or operating with 50-to-1 leverage was safe.
Similarly, regulators, who allowed banks to determine their own capital
requirements and private rating agencies to establish the value at risk in
mortgages and bonds, took it as axiomatic that markets would automatically
generate the best possible information and create the right incentives for
managing risks. ...

The scandal of modern economics is that these two false theories—rational
expectations and the efficient market hypothesis—which are not only misleading
but highly ideological, have become so dominant in academia (especially business
schools), government and markets themselves. While neither theory was totally
dominant in mainstream economics departments, both were found in every major
textbook, and both were important parts of the “neo-Keynesian” orthodoxy, which
was the end-result of the shake-out that followed Milton Friedman’s attempt to
overthrow Keynes. The result is that these two theories have more power than
even their adherents realise: yes, they underpin the thinking of the wilder
fringes of the Chicago school, but also, more subtly, they underpin the analysis
of sensible economists like Paul Samuelson.

The rational expectations hypothesis (REH), developed by two Chicago
economists, Robert Lucas and Thomas Sargent in the 1970s, asserted that a market
economy should be viewed as a mechanical system that is governed, like a
physical system, by clearly-defined economic laws which are immutable and
universally understood. Despite its obvious implausibility and the persistent
attacks on it, especially from the left, REH has continued to be regarded by
universities and funding bodies as the most acceptable foundation for serious
academic research. In their recent book Imperfect Knowledge Economics, two
American professors, Roman Frydman and Michael Goldberg, complain that “all
graduate students of economics—and increasingly undergraduates too—are taught
that to capture rational behaviour in a scientific way they must use REH.” In
Britain too the REH orthodoxy has remained far more powerful than is often
realised. As David Hendry, until recently head of the Oxford economics
department, has noted: “Economists critical of the rational expectations based
approach have had great difficulty even publishing such views, or maintaining
research funding. For example, recent attempts to get ESRC funding for a project
to test the flaws in rational expectations based models was rejected. I believe
some of British policy failures have been due to the Bank accepting the
implications [of REH models] and hence taking about a year too long to react to
the credit crisis.” ...

To make matters worse, rational expectations gradually merged with the
related theory of “efficient” financial markets. ... This was the efficient
market hypothesis (EMH), developed by another group of Chicago-influenced
academics, all of whom received Nobel prizes just as their theories came apart
at the seams. EMH, like rational expectations, assumed that there was a
well-defined model of economic behaviour and that rational investors would all
follow it; but it added another step. In the strong version of the theory,
financial markets, because they were populated by a multitude of rational and
competitive players, would always set prices that reflected all available
information in the most accurate possible way. Because the market price would
always reflect more perfect knowledge than was available to any one individual,
no investor could “beat the market”—still less could a regulator ever hope to
improve on market signals by substituting his own judgment. ...

Why did such discredited theories flourish? Largely because they justified
whatever outcomes the markets happened to decree—laissez-faire ideology, big
salaries for top executives and billions in bonuses for traders. And,
conveniently, these theories were regarded as the gold-standard by academic
economists who won Nobel prizes.

So what is to be done? There are two options. Either economics has to be
abandoned as an academic discipline, becoming a mere appendage to the collection
of industrial and social statistics. Or it must undergo an intellectual
revolution. ...

Economics today is a discipline that must either die or undergo a paradigm
shift—to make itself both more broadminded, and more modest. It must broaden its
horizons to recognise the insights of other social sciences and historical
studies and it must return to its roots. Smith, Keynes, Hayek, Schumpeter and
all the other truly great economists were interested in economic reality. They
studied real human behaviour in markets that actually existed. Their insights
came from historical knowledge, psychological intuition and political
understanding. Their analytical tools were words, not mathematics. They
persuaded with eloquence, not just formal logic. One can see why many of today’s
academics may fear such a return of economics to its roots.

Academic establishments fight hard to resist such paradigm shifts, as Thomas
Kuhn, the historian of science who coined the phrase in the 1960s, demonstrated.
Such a shift will not be easy, despite the obvious failure of academic
economics. But economists now face a clear choice: embrace new ideas or give
back your public funding and your Nobel prizes, along with the bankers’ bonuses
you justified and inspired.

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"Goodbye, Homo Economicus"

Via an email suggestion (there's much, much more in the
full version):

Goodbye, homo economicus, by Anatole Kaletsky: Was Adam Smith an
economist? Was Keynes, Ricardo or Schumpeter? By the standards of today’s
academic economists, the answer is no. Smith, Ricardo and Keynes produced no
mathematical models. Their work lacked the “analytical rigour” and precise
deductive logic demanded by modern economics. And none of them ever produced an
econometric forecast (although Keynes and Schumpeter were able mathematicians).
If any of these giants of economics applied for a university job today, they
would be rejected. As for their written work, it would not have a chance of
acceptance in the Economic Journal or American Economic Review. The editors, if
they felt charitable, might advise Smith and Keynes to try a journal of history
or sociology.

If you think I exaggerate, ask yourself what role academic economists have
played in the present crisis. Granted, a few mainstream economists with
practical backgrounds—like Paul Krugman and Larry Summers in the US—have been
helpful explaining the crisis to the public and shaping some of the response.
But in general how many academic economists have had something useful to say
about the greatest upheaval in 70 years? The truth is even worse than this
rhetorical question suggests: not only have economists, as a profession, failed
to guide the world out of the crisis, they were also primarily responsible for
leading us into it. ...

Academic economists have thus far escaped much blame for the crisis. Public
anger has focused on more obvious culprits: greedy bankers, venal politicians,
sleepy regulators or reckless mortgage borrowers. But why did these scapegoats
behave in the ways they did? Even the greediest bankers hate losing money so why
did they take risks which with hindsight were obviously suicidal? The answer was
beautifully expressed by Keynes 70 years ago: “Practical men, who believe
themselves to be quite exempt from any intellectual influence, are usually the
slaves of some defunct economist. Madmen in authority, who hear voices in the
air, are distilling their frenzy from some academic scribbler of a few years
back.”

What the “madmen in authority” heard this time was the distant echo of a
debate among academic economists begun in the 1970s about “rational” investors
and “efficient” markets. This debate began against the backdrop of the oil shock
and stagflation and was, in its time, a step forward in our understanding of the
control of inflation. But, ultimately, it was a debate won by the side that
happened to be wrong. And on those two reassuring adjectives, rational and
efficient, the victorious academic economists erected an enormous scaffolding of
theoretical models, regulatory prescriptions and computer simulations which
allowed the practical bankers and politicians to build the towers of bad debt
and bad policy. ...

Which brings us to the causes of the present crisis. The reckless property
lending that triggered this crisis only occurred because rational investors
assumed that the probability of a fall in house prices was near zero. Efficient
markets then turned these assumptions into price-signals, which told the bankers
that lending 100 per cent mortgages or operating with 50-to-1 leverage was safe.
Similarly, regulators, who allowed banks to determine their own capital
requirements and private rating agencies to establish the value at risk in
mortgages and bonds, took it as axiomatic that markets would automatically
generate the best possible information and create the right incentives for
managing risks. ...

The scandal of modern economics is that these two false theories—rational
expectations and the efficient market hypothesis—which are not only misleading
but highly ideological, have become so dominant in academia (especially business
schools), government and markets themselves. While neither theory was totally
dominant in mainstream economics departments, both were found in every major
textbook, and both were important parts of the “neo-Keynesian” orthodoxy, which
was the end-result of the shake-out that followed Milton Friedman’s attempt to
overthrow Keynes. The result is that these two theories have more power than
even their adherents realise: yes, they underpin the thinking of the wilder
fringes of the Chicago school, but also, more subtly, they underpin the analysis
of sensible economists like Paul Samuelson.

The rational expectations hypothesis (REH), developed by two Chicago
economists, Robert Lucas and Thomas Sargent in the 1970s, asserted that a market
economy should be viewed as a mechanical system that is governed, like a
physical system, by clearly-defined economic laws which are immutable and
universally understood. Despite its obvious implausibility and the persistent
attacks on it, especially from the left, REH has continued to be regarded by
universities and funding bodies as the most acceptable foundation for serious
academic research. In their recent book Imperfect Knowledge Economics, two
American professors, Roman Frydman and Michael Goldberg, complain that “all
graduate students of economics—and increasingly undergraduates too—are taught
that to capture rational behaviour in a scientific way they must use REH.” In
Britain too the REH orthodoxy has remained far more powerful than is often
realised. As David Hendry, until recently head of the Oxford economics
department, has noted: “Economists critical of the rational expectations based
approach have had great difficulty even publishing such views, or maintaining
research funding. For example, recent attempts to get ESRC funding for a project
to test the flaws in rational expectations based models was rejected. I believe
some of British policy failures have been due to the Bank accepting the
implications [of REH models] and hence taking about a year too long to react to
the credit crisis.” ...

To make matters worse, rational expectations gradually merged with the
related theory of “efficient” financial markets. ... This was the efficient
market hypothesis (EMH), developed by another group of Chicago-influenced
academics, all of whom received Nobel prizes just as their theories came apart
at the seams. EMH, like rational expectations, assumed that there was a
well-defined model of economic behaviour and that rational investors would all
follow it; but it added another step. In the strong version of the theory,
financial markets, because they were populated by a multitude of rational and
competitive players, would always set prices that reflected all available
information in the most accurate possible way. Because the market price would
always reflect more perfect knowledge than was available to any one individual,
no investor could “beat the market”—still less could a regulator ever hope to
improve on market signals by substituting his own judgment. ...

Why did such discredited theories flourish? Largely because they justified
whatever outcomes the markets happened to decree—laissez-faire ideology, big
salaries for top executives and billions in bonuses for traders. And,
conveniently, these theories were regarded as the gold-standard by academic
economists who won Nobel prizes.

So what is to be done? There are two options. Either economics has to be
abandoned as an academic discipline, becoming a mere appendage to the collection
of industrial and social statistics. Or it must undergo an intellectual
revolution. ...

Economics today is a discipline that must either die or undergo a paradigm
shift—to make itself both more broadminded, and more modest. It must broaden its
horizons to recognise the insights of other social sciences and historical
studies and it must return to its roots. Smith, Keynes, Hayek, Schumpeter and
all the other truly great economists were interested in economic reality. They
studied real human behaviour in markets that actually existed. Their insights
came from historical knowledge, psychological intuition and political
understanding. Their analytical tools were words, not mathematics. They
persuaded with eloquence, not just formal logic. One can see why many of today’s
academics may fear such a return of economics to its roots.

Academic establishments fight hard to resist such paradigm shifts, as Thomas
Kuhn, the historian of science who coined the phrase in the 1960s, demonstrated.
Such a shift will not be easy, despite the obvious failure of academic
economics. But economists now face a clear choice: embrace new ideas or give
back your public funding and your Nobel prizes, along with the bankers’ bonuses
you justified and inspired.